How to Use the VIX Index In the Market

In the past year, the investment community has been going through a difficult period. This is mostly because of the many global risks that have been going on. In the United States, there have been challenges in the growing trade deficit and the deadlock in Congress. In Europe, there are signs that the economy is slowing, and in the United Kingdom, Brexit has been a major issue. In Asia, there are concerns about a weakening China and the mini-trade war between South Korea and Japan. In this article, I will explain how investors use the VIX index to forecast risk and allocate capital.

What is the VIX Index?

In 1987, two researchers published a paper on the need to have a volatility index. Their index was known as the Sigma Index, and would be useful in guiding investors about the risks in the market. 6 years later, the Chicago Board of Exchange (CBOE) announced the launch of an index similar to that proposed by the two researchers. In 2003, the CBOE collaborated with Goldman Sachs to develop an updated version of the index. The updated index looked at the S&P 500 companies while the previous one looked at the 100 companies. The VIX index, also known as the fear index, is used by investors to gauge the fear in the market.

How the VIX Index is Calculated.

As an investor, you don’t need to understand how the VIX index is calculated. Instead, you just need to know how it is used in the real market. The VIX index is calculated by looking at the S&P 500 companies and how investors have applied options into them. The calculation takes into consideration the time to expiration, the forward index level derived from index option prices, first strike below the forward index, and the strike price of the money option. By doing this calculation, investors are able to know how investors have positioned themselves for the future. More details on this calculation can be seen here.

How to Use the VIX Index

Consider the headline below.

 

There are two primary methods in which you can use the VIX index in the market. First, you can trade or invest in the VIX index derivatives. The first VIX derivatives were started in 2004 and were listed at the CBOE. Most brokers in the United States like Schwab, Interactive Brokers, and TD Ameritrade allow you to trade the VIX index. To do this, you need to do two things. First, you need to conduct a technical analysis, using tools like the moving averages, RSI, and relative vigor index to identify areas where you can initiate the trades.

Second, you need to do a fundamental analysis, to predict whether the VIX will go up or not. In this fundamental analysis, your goal is to look at the global risks and conclude on whether you expect them to rise or not. For example, you can buy the VIX index if you expect there to be a no-deal Brexit. You can also short the index if you expect the world to be relatively calm.

The other way you can use the VIX index is to use it as a predictor of how the market will react. In this, if you expect the VIX index to keep on moving high, you can place a trade that shorts the overall stock market. Alternatively, you can buy safe havens like gold, Japanese yen, Swiss Franc, and government bonds when you think that the VIX will move high.

Summary

The VIX, also known as the fear index is one of the closest-followed indices in the financial market. Its performance is usually baked-in many models used by investment managers. It is also used by many sophisticated traders as a signal of what to expect. Therefore, as a trader, you should always consider looking at the performance of the VIX before you make any investment.